The Hidden Cost Of Ignoring Evidence

An advisor recently told me that he lost a large client to another firm. This advisor said he had carefully explained the benefits of evidence-based investing to the prospect and thought he had made a convincing case. The firm that got the business indicates on its website that its core competency is its ability “to select outperforming fund managers.”

The losing advisor was distraught and confused. He wanted to know if I could help him understand how the prospect could make such an “irrational” decision.

The evidence on fund manager selection

On the merits, this advisor was 100% correct. The data on the inability of fund managers to “beat the market” year after year is overwhelming.

Rick Ferri recently reviewed the June 2015 S&P Dow Jones Indices Versus Active (SPIVA) Persistence Scorecard and noted that only 5.28% of the 682 U.S. equity funds among the top quartile in March 2013 were able to maintain that distinction by the end of March 2015. He also observed the difficulty fund managers have remaining in the top half of funds, ranked by performance, for more than a few years.

Other studies, including a seminal study by Nobel laureate Eugene Fama and Kenneth French, have established conclusively that few actively managed funds produce benchmark-adjusted expected returns sufficient to cover their costs.

Despite vast resources, even the most sophisticated investors (like retirement plans, foundations and endowments) have a dismal track record in their attempts to select outperforming fund managers. One study looked at the fund selection and termination decisions of 3,400 plan sponsors between 1994 and 2003. It found that if plan sponsors “had stayed with fired investment managers, their excess returns would be no different from those actually delivered by newly hired managers.”

Why, then, are advisors who look for the next “hot fund manager” successful in persuading prospects they have a skill that can’t be found in the academic literature?

The evidence on evidence

The distraught advisor who lost his prospect was proceeding on a commonly held, but flawed, assumption. He thought marshaling the evidence in a persuasive way would capture the business.

He would have been correct in his approach if decision-making were based solely on a careful, rational and objective review of the data. Unfortunately, it isn’t.